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Much work has been done in recent years on the subject of insurance regulation and capital requirements, and the process of regulatory reform will continue. It behooves insurance supervisors to take a step back, revisit the underlying assumptions that have driven supervisory reform in the various sectors, and assess what implications, if any, their conclusions have for future work. The use of internal models to establish regulatory capital requirements cannot and should not disappear. However, they must be used appropriately, with recognition of their significant limitations. The optimal structure of insurance supervision is likely to be a combination of a rules-based and a principles-based approach. That is, internal models should be an adjunct to a rules-based capital requirement that establishes a floor for regulatory capital. Capital regulation is a necessary, but not sufficient, additional requirement for effective financial regulation. On-site examinations, offsite analysis of financial performance and trends, and frequent interaction with the regulated entity are equally important. Finally, current developments have demonstrated that market discipline cannot be relied on as a substitute for regulation and supervision. The optimal regulatory structure is one that encourages supervisors to take action when it is appropriate, and a system that incorporates duplicative regulatory oversight may advance that objective.

S. 40, the National Insurance Act of 2007, requires the development of a system of Prompt Corrective Action (PCA) for federally chartered insurers. This paper discusses the issues associated with developing a system of PCA and makes recommendations regarding its structure. First, the paper considers the historical motivation for the development of PCA in banking and insurance. Second, the paper provides an overview of PCA in banking and reviews the evidence regarding the extent to which banking regulators rely on PCA and its effects on FDIC costs. Third, the paper provides an overview of the risk-based capital requirements in insurance, and compares those requirements with PCA in banking. Fourth, the paper considers the banking requirements related to Least Cost Resolution (LCR) and related language in S. 40. The paper concludes that PCA requirements should be included in any Optional Federal Charter (OFC) legislation, and that NAIC RBC requirements provide a good initial structure. Second, the paper concludes that other regulatory authority giving the Commissioner discretion to intervene beyond PCA is essential in any OFC system. S. 40 would benefit from the inclusion of a provision requiring review of costly insolvencies and transparency with respect to the results of that review and the costs of resolving insolvent insurers. Finally, S. 40 provides a clear objective for resolving insolvencies, a positive change from current insurance laws, but the appropriateness of the objective is dependent on the continued existence of the current guaranty fund system.

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